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Components of total return

While price volatility causes investor anxiety, rather than being anxious, investors should focus on the income that investments generate over time. Admittedly longer term means more than 5 years when it comes to equity investments.

The income element of the total return equation is far steadier than daily, weekly, monthly price movements.

There are essentially 3 components to an investor’s total return when investing into a company.

• Initial dividend yield;
• The growth of those dividends over time;
• The rating change (i.e. the change in the valuation of the share from the time acquired to the time valued or sold – either negative or positive)

When measured over various time periods, 10, 15, 25 and 40 years for example, dividend growth as the predominant driver of equity returns has been remarkably steady.

If an investor capitalises on buying when starting yields are juicy, i.e. attractive starting prices, then this initial yield serves as a very long run booster to the total return.

On the other hand rating change (changes in valuations of company earnings / dividends), depicted by price volatilities has not contributed substantially to the total return. We know that over discrete periods of time, markets can move from undervalued to overvalued and this can add immensely to an investor’s total return, but over longer periods of time, this rating change is mean reverting and so does not feature as a permanent component of the total return to an investor.

Annually JP Morgan update a total return report across all local asset classes. The components of total return for local equities can be depicted as follows: firstly price return, which is the aggregate of dividend growth and rating change and then adding this to the starting dividend yield gives the total return.

This chart indicates that in nominal terms, dividend growth has tended to average around 12% per annum. Over the 40 year period, rating change has added 2,6% per annum to total return.

Source: JP Morgan

Adding the starting dividend yield to the price return, gives an investor his total return. Over the 40 years to the end of 2009 the JSE has provided investors with a total return of around 20%.

Over the past 50 years, the total return has been very similar at 19,4%.

Given the fact that earnings growth was strong over the past 5 years together with fact that inflation should remain at the lower end of its historical number, the nominal expected return from a basket of listed equities should be closer to the 12% - 15% range than 20% going forward.

Assuming a long run inflation of 5-6%, then long term investors should still expect a 7% - 8% real rate of return, which is better than bonds or money market, albeit at higher volatility.

Global economy fears send markets sliding

At noon on Wednesday, the JSE All Share was down by 0.1% with losses almost across the board as investors became increasingly worried about the global economic outlook.

Due to a lack of news, the rand was relatively unchanged, trading at R7.62 to the US dollar at midday.

Oil cost $75 a barrel, rising 1.35% yet still approaching a negative finish for the quarter as the outlook for demand dimmed in line with growing pessimism about the health of global economic recovery.

International markets

On US markets yesterday, the Dow Jones closed 2.65% lower and the Nasdaq plunged 3.85% after a surge of global economic worries spurred selling.

Japan’s Nikkei index slid 1.96% this morning, to reach its lowest level in seven months, and possibly its worst quarter since 2008.

Hong Kong’s Hang Seng finished 0.59% lower before tomorrow’s public holiday as investors decided to sell off their riskier assets on renewed fear for the global economy.

Britain’s FTSE 100 had lifted by 0.72% at midday, after gains in pharmaceutical shares offset the effect of persistent fears about the euro zone banking system.

Investing into higher yielding shares

Local and global markets continue to move up and down at a pace that makes the Cobra roller coaster ride look like a children’s merry go around. Global markets have been under pressure this week on the back of weak economic news – but when investors are looking for a reason to sell, they will find anything.

This type of market tends to scare many investors into assets where there is low price volatility, with cash / money market being one of the most favoured asset class for risk averse investors.

Unfortunately however interest rates have declined to the point where money market rates are not paying much above the inflation rate and while investors will not lose money in nominal terms, over time there is an expectation of little to no growth growth.

Some investors have the luxury of not concerning themselves with the day to day fluctuations of the prices of the companies in which they are invested. Investors that have a longer term investment horizon will rather look to the steadiness of the dividends that they can generate over time.

The investor that has this absolute luxury is one that has a moderate income requirement, relative to their capital base. These investors can build a portfolio of dividend paying shares, trading at reasonable yields, where there is a good possibility that dividend growth will at least match inflation over time, or ideally be sustainable at a couple of percent ahead of inflation per annum.

Seed has recently launched a unit trust fund, the Seed Flexible fund, which will be managed within prudential guidelines – i.e. the same guidelines as pension funds. As multi managers, we continue to outsource the management of the various components of the fund.

I have highlighted some of the direct equity positions in the portfolio, looking at the historical yield, analyst expected dividends, growth and possible yield on these shares 2 years out. In a market that is not trading at cheap levels, it is still possible to find reasonably attractive shares, that should provide investors with steady dividend growth over time.

These shares are included within the local equity allocation:

While there are no guarantees, we do know that dividends are far more stable that share prices. Selected shares paying a 4,5 and 6% tax free dividend yield on current in 2 years time will be attractive relative to cash rates.

If you would like to know more about the fund, please don’t hesitate to contact us, or visit the website seedinvestments.co.za.

Increased regulation

The biggest global bond manager, US based Pimco, which manages over a $1 trillion, recently had their annual secular forum, where they internally discuss a three to five year outlook for the global economy and markets.

Part of what co chief investment officer, Mohammed El-Erian noted as the bottom line, and in a continuation of their theme of a New Normal, he stated, “Through a series of transitions, collisions, and trade-offs (the journey), we are heading to a world that is re-regulated, de-levered, and growing less rapidly in the industrial countries (the destination). “

The re-regulation of the world, especially but not exclusively in the banking sector, is high on the political agenda and is likely to stay that way for some years to come.
Just this past weekend we saw leaders of the G20 meet in Toronto, where banking regulation was a major topic.

While the official communiqué speaks to unity on various issues, one report noted that “The G20 meeting amounted to a parting of the ways as ministers effectively agreed that countries should decide themselves what to do on issues like ….financial reform..”
The official communiqué noted that “we are building a more resilient financial system that serves the needs of our economies, reduces moral hazard, limits the build up of systemic risk and supports strong and stable economic growth.”

Getting to a global consensus is not easy and for this reason there has been a relaxation in the timetable for tighter capital requirements of banks. Previously the target date for new capital requirement laws was to be achieved in 2012 but this has now been delayed and it looks like it could be set by country or region.

Currently the core tier one capital of a bank to its risk weighted assets is 2%. This is expected to double and perhaps go even further, but with only tentative signs of the global economy picking up, politicians are treading more cautiously.

As a general rule higher taxes, more regulation, tighter capital adequacy, a firming of cross border trade etc all serve to escalate the cost of doing business and dampen the returns of the owners of equity. These additional costs will need to be factored into the return expectations.

Investment manager selection

I have been discussing the approach that multi asset manager, Russell Investments takes when evaluating various investment fund managers for inclusion into their portfolio. We have looked at 6 of their categorizing criteria namely, people, process/philosophy, portfolios, performance, passion and perspective.

The last 2 criteria that they include as part of their New 4 P’s are Purpose and Progress.

Some of the characteristics that they look for under these 2 heading, when assessing investment management firms:

• Purpose

Managers with purpose are committed to their investment philosophy. They noted that when evaluating purpose, they will look at several factors, including the structure of the firm. Generally managers that have large personal stakes in their firms are often the most committed to achieving successful outcomes for their clients.

Other factors include staff training and individual roles and responsibilities.

• Progress

A characteristic of managers who are willing to progress is that they are not comfortable with the status quo. These managers tend to be never pleased or contented with performance but rather recognise that markets evolve and they need to remain relevant and effective.

They look at how their investment process evolves over time, how changes to the investment team is handled and how they adapt their thinking to new information.

While they continue to use the old 4 P’s in order to provide a framework for meeting and beginning the analysis of money management firms, they believe that the New 4 P’s (passion, perspective, purpose, progress) give greater focus on what they have observed to be characteristics of successful firms.

Global markets fall as economic recovery concerns grow

At midday on Friday the JSE All Share had lost 0.51%, as resource shares fell during a small-volume yet volatile morning session.

The rand was trading at R7.66 to the US dollar at noon, slightly weaker but remaining range bound and looking to the euro for direction.

Brent crude oil was selling at $75.26 a barrel, recovering 0.35% after slipping on news of higher inventories and the threat of a Caribbean storm which might extend toward the Gulf of Mexico, where BP is trying to combat a devastating oil spill.

International markets

On US markets yesterday, the Dow Jones closed 1.41% lower, while the Nasdaq dropped 1.68% after investors sold off stocks on signs of weak consumer demand and concern over stricter financial regulation.

Japan’s Nikkei average lost 1.92% this morning after lower consumer spending suggested a more pessimistic outlook for corporate earnings.

China's Shanghai index finished 0.54% lower, but managed to reach its best week for the month thanks to gains earlier in the week after China promised to relax control of the yuan.

Britain's FTSE 100 was down 0.65% at midday SA time, as bank shares rallied after signs of compromise in US regulation plans, and before the upcoming G8 and G20 summits.

G 20 Summit - Toronto

Last year we took a look at the emergency G 20 summit held in London in the midst of the global financial crisis (April 2009) just one month after global markets bottomed. In the report we discussed how co-ordinated all the countries were in the need to bring the global economy out of the recession.

In an environment of widespread stress, it was fairly easy to get consensus on what needed to be done over the short term to return to a path of growth. This meeting, currently being held in Toronto, Canada, has G 20 members divided on what is required going forward. This is a result of the fortunes of the different countries deviating over the past year or so.

We’ll take a brief look at some of the conflicting objectives of some of the member nations:

South Africa: While the economies of the developed markets are not completely out of the woods, they’ll continue on introspection (i.e. assisting their own economy). President Jacob Zuma, and Finance Minister Pravin Gordhan have the task of reminding these world leaders that Africa, and other developing regions, continue to need to foreign direct investment. South Africa will also look to reposition itself in order to stimulate growth, i.e. target our trade with high growth regions.

China: A few of the issues that China will be addressing are the need for greater representation by emerging markets and developing countries. Clearly in a climate where there is temptation to protect one’s own market, China, the world’s largest exporter, will oppose any plans that promote trade protectionism.

United States of America: The US will target continued stimulus around the world. Their fears are that a premature withdrawal of stimulus could plunge many economies back into recession. They would rather aim for growth, and deal with the ramifications of high debt levels in the future. The US will be pleased that China has announced a fresh round of exchange rate reform (i.e. let its currency appreciate to improve relative competitiveness of other countries).

Germany: Angela Merkel of Germany doesn’t want to stimulate consumption expenditure by increasing government expenditure (Keynesian economics) arguing that Germans will only spend more if they are comfortable that the government is fiscally strong, and will be able to support them if necessary. As part of the EU she needs to look at the region’s interests as well. While the euro is weak the export heavy country is able to boost its exports.

Canada and Great Britain: One thing these two countries have in common is the desire to reduce government deficits going forward (over the next 5 years or so). A major point of contention is that Britain desires a global bank tax to avoid taxpayers having to bail out banks in the future, while Canada is vehemently against such a levy.

France: After a fairly extensive search of France’s views didn’t reveal much, I realised that Nicholas Sarkozy probably has his hands tied up at the moment with an enquiry into the French football team’s lack of performance, and off field shenanigans after being knocked out the FIFA World Cup first round, without a win to their name, earlier in the week.

Revived concern over the sustainability of economic recovery weighs on JSE

Local markets

Thursday noon saw the JSE All Share down 0.47% with losses across the board, after investors renewed their concerns about the sustainability of the global economic recovery.

The rand was trading at R7.60 to the US dollar, remaining within a range as the local currency followed movements of the euro-dollar exchange rate.

Oil cost $75.69 a barrel, recovering by 0.92% at 12:00 after two days of losses, taking a lead from steady Asian markets.

International markets

Yesterday, the Dow Jones edged up 0.05% but the Nasdaq dipped 0.33% after volatile trade, as the US Federal Reserve downgraded its assessment of the economic recovery and promised that loans would remain cheap.

Japan’s Nikkei index inched up 0.05% this morning to close flat, but held above a key support level after a volatile session.

Hong Kong’s Hang Seng fell 0.59% on profit taking after the US Federal Reserve announced a mixed economic outlook.

Britain's FTSE 100 had lost 0.78% by noon led by losses in commodity stocks, while waning risk appetite saw bank shares slide.

Investment manager selection criteria

Yesterday we looked at some of the factors that multi managers look at when systematically working through the thousands of fund managers. A presentation from global multi managers, Russell Investments, noted their New 4 P – as distinct from their old 4 P.

They note that they developed their new 4 P’s as a complement to their original manager research approach. The New 4 P’s are passion, perspective, purpose and progress and they believe that these allow them to categorize the characteristics of firms that will enable an improvement in identifying superior investment managers.

Let’s consider some of their thinking on 2 of these characteristics.

• Passion

This is a powerful emotion. They look for highly motivated and intensely competitive investment mangers focused on excellence if not perfection. Although passion is largely an intangible factor it can be identified in the communication that the firm puts out, the words that are used, the intensity of the people, low personnel turnover, etc.

An example of passionate behaviour is provided of a manager that for at least 20 years starts his day at 5:00am looking through data that his systems have been gathering overnight, before heading to the office. After a full day in the office doing classical fundamental research of speaking with company management, suppliers, competitors etc, he will after dinner be back at his home office until around midnight.

Although passion is not exclusively the domain of owner managed firms, it tends to be the case.

• Perspective

Their view is that “managers with perspective know the limits of their capabilities and, generally possess strong sell disciplines.” They go on to cite an example of a firm that after a strong 2 year performance, called their clients and returned capital, given their inability to come up with new ideas in an expensive market. This behaviour indicated perspective in that the manager knew what his limitations were in a certain type of market.

Another example of perspective mentioned is on underperforming shares. Many managers faced with underperformers simply sell and move on, but managers with perspective spend more time analysing why they made certain decisions and attempt to learn from their mistakes.

These characteristics may not be easy to quantify but because there should be a low turnover of investment managers in a composite portfolio, it is important to make an evaluation on a strategic level.

Losses in oil and gas shares weigh on JSE

Local markets

Wednesday midday saw the JSE All Share down 0.76% led by losses in oil and gas stocks. The local bourse was affected by negative sentiment as investors became more risk averse after poor US economic data.

The rand was trading at R7.55 to the US dollar, slightly weaker as recent event risk is making investors cautious.

Brent crude was selling at $77.10 a barrel, up 0.25% after falling overnight on news of increased US inventories and weak home sales.

International markets

Yesterday on US markets, the Dow Jones closed 1.43% lower and the Nasdaq gave up 1.19% in a late selloff, as investors reacted to unexpectedly poor home sales data.

Japan’s Nikkei average fell 1.87% this morning, as concerns about the euro zone and bleak technical markers spurred selling.

China’s Shanghai index fell 0.73% as cheer over a more flexible yuan faded and poor economic data from the US inspired losses.

Britain’s FTSE 100 was 0.58% down at midday, as losses in commodity shares weighed, adding to recovery worries after the release of weak economic data from the US.

Manager research

With thousands of professional investment management firms around the world, selection becomes a very important process. Multi managers have tried to identify key drivers and in so doing develop manager research processes.

Russell investments, an international fund manager in investment funds, put out a recent presentation on their manager research process. This is something that they started in 1969 and so over the years have refined their methodology of selecting money management firms around the world.

Naturally in making selections, the idea is to try and identify the key success factors. Their original focus was on what they now term the old 4 P’s, being people, process / philosophy, portfolio and performance, which is typically used in due diligence processes.

While they have developed the New 4 P’s they still consider the old 4 P’s an important part of manager selection. I will cover the New P’s in a later article, but what most multi managers focus on is:

• People

Because investment management is a people business, it is important to gain a good understanding of the teams and or individuals behind the business that are expected to generate the returns that clients expect.

One must understand who these people are, background, qualifications, and track records etc. Are they team driven, or does the business revolve around one person?

• Process / philosophy

Having a defined investment philosophy is critical to long term sustainable results. Because philosophies can vary from firm to firm, a properly defined investment process will see that the philosophy is implemented. A multi manager should gain a clear understanding of the philosophy and processes involved and also how this matches up with the characteristics of the people in the organisation.

• Portfolios

This is an important step that Russell Investments identified, which is to analyse the portfolios going back over time and to assess how these have matched the firms adopted philosophy. For example where a manager espouses a value philosophy but in the past had the bulk of the portfolio invested in growth shares, this could be indicative of an unclear investment process.

• Performance

This is often mistakenly used as the first step in manager selection, but should come near the end. Clearly one should be looking for superior past performance, but its more important that all aspects of the due diligence line up. For example a value firm displaying 3 year poor outperformance against the market, may still be in the running if the past 3 years was a growth market, where value investors tend to underperform.

I will look at some of the other factors that one should consider tomorrow.

Yesterday, the Dow Jones finished 0.08% lower and the Nasdaq lost 0.90% on late selling as confidence in China's decision to allow yuan flexibility dissipated as investors questioned the speed and extent of Beijing's intentions.

Japan’s Nikkei average closed 1.22% down this morning, after investors took profits after the index rose to a one-month high the day before.

Hong Kong’s Hang Seng dipped 0.45% after profit taking on the back of yesterday’s rally spurred by China's decision to allow the yuan more flexibility.

Britain’s FTSE 100 had lost 1.26% by noon SA time, with losses in commodity and bank shares weighing after confidence inspired by China's yuan decision waned.

BP Crisis

2 months ago BP plc was the fourth largest company in the world and one of the largest in the United Kingdom. It was the pride and joy of the British people and like their soccer team has now fallen out of favour.

With an explosion on an oil rig in the Gulf of Mexico on the 20 April, the worst environmental disaster of our lives has started. Since then more than 151 million litres of oil has been spilled into the ocean. But due to and lack of action form BP and a few PR screw ups their share price dropped like a stone. The share price dropped to $29 on the 9 June, when the BP came under the US Congressional enquiry. Last week BP CEO Tony Hayward was questioned by the US lawmakers on how this happened and the future plan of action. The chief of BP was very evasive during the questioning. BP is now being forced to cancel their dividend payouts and to set up $20bn fund for compensation claims.

The graph below shows the drop of BP plc share price over the last year.

Data Source: Google Finance

The marine life in the Gulf of Mexico is not the only thing that has been affected.

The already struggling UK pension fund industry was dealt another blow from this disaster.
Last year BP paid £6.6bn out in dividends. The annual dividend payout is one of reasons why income hungry pension funds have a high exposure to BP. If you want to compare income from dividends to the other companies in the FTSE 100, for each £1 you received from BP you would have received £6 from the other FTSE 100 companies.

During the last 2 months BP lost $90bn in market capitalisation and with pension funds high exposure to BP, more than a billion pounds have been wiped off the value of the pension funds. The nest eggs of thousands of employees have been dealt another blow after the market crash of 2008.

The UK government is also affected. Last year BP paid £5bn in taxes and the year before that £10bn. In a period where a few European countries are already struggling with debt, the UK government will be forced to look at their spending and make sure that it is able to balance its books to avoid to be placed in similar position as Greece. The oil spill will also be affecting the tourism and fishing industry in the US.

Until BP is able to plug the hole, hopefully mid-August, thousands of barrels of oil will be leaking into the ocean. In the mean time BP will have a long list of To Do’s. The will need to clean up over 160km of effected coastline. They will need to mend the relationships with their customers who are very vocal about this incident, compared to them. They must also be ready for possible takeovers, now that their share price has fallen so dramatically. At least the CEO was able to take a bit of break over the weekend and was able to attend a yacht race this weekend.

Gold in US dollars

The chart of the day site today reflected a long term chart of the gold index in US dollar terms. Over the last 9 years or so, gold having been in a 2 decade slide until 2001, has silently but persistently crept higher and higher in US dollar terms.

As the price has moved up higher so it has started catching the attention of many global investors.

Two other factors making gold attractive is the volatility in the currency markets together with the fact that cash in dollars and euro is earnings close to 0% interest.

This is the commentary from chart of the day:

As today's chart illustrates, gold has been in a strong bull market since 2001. The pace of that upward trend increased beginning in mid-2005. Following the financial crisis of late 2008, gold surged once again. While gold made another record high today, it still trades significantly below resistance (red line) of its upward sloping trend channel. In the end, with gold currently trading near $1,250 per ounce, gold has more than quadrupled in price during its nine-year bull market.

Gold price in US dollars

Gold in itself is not an easy asset to value, given the lack of cash flows. However given the trend and the fact that gold has not become hugely speculative as yet, there is a possibility that the upward trend continues for the foreseeable future.

Market Timing

Much gets written about the pros and cons of market timing, with the conclusion typically dependant on the view point of the author. There is also often much confusion between market timing and tactical asset allocation.

Market timing (our definition) is the process whereby an investor increases their position in risky assets (equities) at the expense of lower risk assets (cash and bonds) and vice versa. This allocation is typically done on news flow, some form of cognitive decision (typically influenced by some form of behavioural bias), or some updated forecast. While there are undoubtedly investors who are able to capitalise using this strategy, the large majority of investors will negatively impact their returns by engaging in market timing.

Humans aren’t rational beings, and our actions are often incorrectly influenced by our inherent biases, which negatively affect investment performance. An example is switching into an asset class that has performed well over an extended time. Some research on market timing, that I found courtesy of global management company, VAM, is displayed below:

Market research company, DALBAR conducted the above research based on flows in and out of mutual funds. This research shows how much value a market timing strategy can destroy. Investors, on a whole, destroy capital on a consistent basis as a result of their cash flows in and out of investments. Other studies also show how the average investor does worse than the performance of the fund that they invest into as a result of the timing of their cash flows.

James Montier of GMO used a quote of Ben Graham and Dodd to distinguish between market timing and (tactical) asset allocation adjustments:

The general dislike of market timing can be summed up by Graham and Dodd’s statement, “It is our view that stock market timing cannot be done...” However, less well-known is the fact that he continues this sentence, “with general success, unless the time to buy is related to an attractive price level, as measured by analytical standards. Similarly, the investor must take his cue to sell primarily not from so-called technical market signals but from an advance in the price level beyond a point justified by objective standards of value.”

Essentially what is being proposed here is tactical asset allocation where the investment decision is based on solid valuation considerations, and not other reasons. Fighting our natural biases is crucial in avoiding the associated capital destruction.

Afghanistan discovery

An interesting news item popped up in the last couple of days. The US discovers vast untapped mineral wealth in Afghanistan – with an initial estimated value of some $1 trillion. Even if there is a 50% over estimation of this number, it is massive in relation to the size of the economy.

The US, according to World Bank figures, is a $14,1 billion economy (using 2008 figures). Afghanistan by comparison is measured at just $10,6 billion, and now around $12 billion and so very tiny. The war torn country is known for its opium production and not for mining, but things could change in the years ahead if there is some truth in this news.

South Africa’s GDP, measured on the same basis is at $276 billion and Australia just over $1trillion.

Some of the deposits that apparently exist in the area include irons, copper, cobalt, lithium, gold. The deposits of iron and copper are said to be of sufficient size to make Afghanistan a possible major world producer.

Lithium is the key ingredient for many types of the batteries used in cell phones and laptops. According to news reports the Afghanistan mineral wealth was discovered by a small tem of Pentagon officials and US geologists.

The country has absolutely no mining infrastructure or industry and so to develop this even in a peaceful country would take years. Complications naturally arise in a country that has been perpetually at war

According to the New York Times,” In 2004, American geologists, sent to Afghanistan as part of a broader reconstruction effort, stumbled across an intriguing series of old charts and data at the library of the Afghan Geological Survey in Kabul that hinted at major mineral deposits in the country. They soon learned that the data had been collected by Soviet mining experts during the Soviet occupation of Afghanistan in the 1980s, but cast aside when the Soviets withdrew in 1989.

During the chaos of the 1990s, when Afghanistan was mired in civil war and later ruled by the Taliban, a small group of Afghan geologists protected the charts by taking them home, and returned them to the Geological Survey’s library only after the American invasion and the ouster of the Taliban in 2001.

The data from those flights was so promising that in 2007, the geologists returned for an even more sophisticated study, using an old British bomber equipped with instruments that offered a three-dimensional profile of mineral deposits below the earth’s surface. It was the most comprehensive geologic survey of Afghanistan ever conducted. “

The possible future development of large scale mining in such an area will naturally have implications for existing countries reliant on resources such as SA. We will be interested to see how this story develops over time.

James Montier on risk

James Montier who sits on the asset allocation team of US based fund managers, GMO, wrote an interesting article recently, looking at strategic asset allocation. He made a number of interesting observations on risk which I have expanded upon here.

Modern portfolio theory looks to optimise risk and return in order to construct an efficient portfolio of stocks and bonds. But in trying to put a number to risk the definition has traditionally been risk equals volatility. i.e. the more volatile an asset the riskier is that asset.

But volatility is not the same as risk and a better definition of risk would be the permanent loss of capital. i.e. “What is the chance that I will see my capital permanently impaired by this investment?”

Actually volatility is exactly what investors need in order to generate excess returns. As John Maynard Keynes noted years back, “It is largely the fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”

Risk does not equal volatility

Source: GMO, SG

Standard finance says that high volatility equates to high risk, but history points to the exact opposite. The chart above indicates that times of low volatility were typically followed by asset price declines, while high volatile times were great opportunities to invest.

He notes that risk is a multifaceted concept and it is foolhardy to try to reduce to single figure. He notes 3 possible reasons for a permanent loss of capital

• Valuation risk – pay too much for an asset
• Business risk – there are fundamental problems with the asset
• Financing risk – leverage

He goes on to say that this definition of risk puts valuation at its core, making value investing a truly risk averse approach. It’s why we continue to place an emphasis on valuations of assets.

S&P500 price to earnings

Chart of the day in the US had a very interesting long term chart on the price to earnings multiple of the S&P500 index going back to 1935. This is what they noted:

Today's chart illustrates how the recent rise in earnings as well as the recent pullback in stock prices has impacted the current valuation of the stock market as measured by the price to earnings ratio (PE ratio).

Generally speaking, when the PE ratio is high, stocks are considered to be expensive. When the PE ratio is low, stocks are considered to be inexpensive. From 1936 into the early 1990s, the PE ratio tended to peak in the low 20s (red line) and trough somewhere around seven (green line). The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s), surged even higher during the dot-com bust (early 2000s), and spiked to astronomical levels during the financial crisis (late 2000s).

Currently, the PE ratio stands at a touch below 18 which is near the lowest levels that have existed since the early 1990s.

More on soccer

Soccer World Cup fever is now pervasive across the country and at this time tomorrow with the opening 2 matches having been played, I thought lets look at some stats in a recent Goldman Sachs report.

Of the 19 world cups to date one of 4 countries (Argentina, Germany, Italy and Brazil) has been in every final.

Brazil will host the 2014 World cup and the 2016 Olympics. Larger countries definitely have an advantage in world cups – quite simply the bigger the population of soccer players, the more to select from. Brazil is the largest populated country in Latin America.

In December 2008 Fifa started a 2 year bidding process for the host of 2018 and then 2022 world cup. The decision will be announced on 2 December 2010. The likelihood is that a European country will host the 2018 event – one of England, Russia, Belgium/Netherlands or Portugal/Spain.

The 2022 event will then come down to US, Australia, Qatar, Japan or South Korea.

Rankings and gross national product

Goldman Sachs attempted to see if there is a correlation between GNP per capita and the current FIFA rankings. They found that this was -0.17 indicating that there is a very weak relationship between GNP per capita and a country’s FIFA ranking.

Odds

The chart below is what the bookmakers were pricing in across the countries at the beginning of May. Looking at the current odds quoted by Ladbrokes today, they still have Spain at 4/1 but have moved England to 7/1 and Argentina to 6/1.

Categorising types of companies

Peter Lynch was the famed portfolio manager of Fidelity’s (the US based global investment company) Magellan fund between 1977 and 1990. His stock selection process emphasised familiar businesses, fundamental analysis, a solid understanding of the business, its competitive environment and prospects etc.

Peter Lynch advocated stock selection on the story that each company told. i.e. he looked at company expectations which were derived from the company’s story in terms of its business model, its customers, business prospects, strategy etc.

In this way he wanted to ensure a solid understanding of the businesses in which he invested.

He categorised companies in order to help develop the story and come up with reasonable expectations of future earnings and prospects.

He identified 6 types of companies:

1. Slow growers – these are large companies, raising earnings at about the same rate or only slightly higher than the economy. They are steady dividend payers. These companies were not amongst his favourite.

2. Stalwarts - good companies with solid EPS growth of 10-12% - companies like Coca Cola, Pfizer etc. If purchased at a good price they can produce good but not necessarily spectacular returns.

3. Fast growers – these are small, aggressive new companies which perhaps are growing their earnings at 20-25% or more. Not necessarily in fast growing industries, these companies were amongst his favourite

4. Cyclicals – these are businesses whose earnings rise and fall as the economy moves through up and down cycles in a somewhat predictable, but not failsafe fashion. Examples include commodity suppliers, airlines, motor manufacturers etc.

5. Turnarounds – These are businesses that have had temporarily depressed earnings for whatever reason. The prices of many of these can move up sharply from a depressed position.

6. Asset plays – these are companies that have a high underpin of net asset value and which are often overlooked. For example, occasionally one may find a company with property valued at a low historical cost on the balance sheet. These asset plays are not always easy to find and require work.

Again some interesting insight from a fund manager with a very different process to the growth bias manager discussed yesterday

Financial, resource shares boost JSE

At noon on Wednesday, the JSE All Share was up 1.08%, lifted by gains in financial and resource shares, and tracking positive movements on international markets.

The rand was trading at R7.73 to the US dollar at midday, taking direction from the euro which remained relatively unchanged from overnight levels.

Brent crude oil rose 1.82% to sell at $72.29 a barrel, after news of solid Chinese exports and an industry report showing a bigger drop in US oil inventories than was anticipated.

International markets

Yesterday on US markets, the Dow Jones rose 1.26% led by gains in material and financial shares, while the Nasdaq slid 0.15% as investors sold big-cap technology shares on fears for their European exposure.

Japan's Nikkei index closed 1.04% down this morning as investors worried about Europe’s debt problems after Fitch Ratings remarked that the UK had a "formidable" fiscal challenge ahead.

Hong Kong’s Hang Seng inched up 0.69% after China's securities regulator gave Agricultural Bank of China the green light to begin an initial public offering.

O Neil's growth drivers to stock selection

Most successful investment managers have defined an investment philosophy and investment process for themselves. One feature of investing is there is not only one investment philosophy or process that all must adhere to. For example, while we believe that over time a value bias is superior, a fund manager preferring to concentrate on growth drivers can developing a competing strategy to a value manager.

William o Neil is a growth stock investor who started in the late 1950’s as a stockbroker. After studying the market he found what he believed to be a winning approach. He found that shares that broke out of a long consolidating phase and started setting new highs, often went on to make major price advances.

"What seems too high and risky to the majority generally goes higher and what seems low and cheap generally goes lower."

In addition to investing, he has written books, launched the financial newspaper called the Investor’s Business Daily, as well as an investment data service tracking 10 000 companies.

Method and guidelines

His investment methodology is a mixture of quantitative and qualitative criteria to pick stocks, but with the main idea of looking for those companies that have the greatest potential for swift price rises from the moment you buy them. Essentially buy the strong, sell the weak.

The firm’s trademarked acronym is C-A-N-S-L-I-M.

C = Current quarterly earnings
The first investment criteria that a company must exhibit is quarterly or bi annual earnings increases of 40-500%.

A = Annual earnings increases
Look for companies with at least 5 years of prior growth, at a compound rate of no less than 25%. Prefer those with the most consistent growth. The P/E ratio is relatively unimportant. On average, it may range from 20 to about 45.

N = New products, new management, new highs
The best stocks have a new story behind them, such as new and exciting products or new directors. They are also breaking out to new highs. On a chart, they typically form a shape that looks like 'a cup with a handle'.

S = Supply and demand
The less stock there is to buy, the more any buying will drive up the price. Watch for a rise in the amount of shares traded ('volume') of at least 50% above average.

L = Leaders and laggards
Stay with the 2 or 3 stocks showing the highest relative strength in their sector. They should have outperformed 80-90% of all other stocks in the last 12 months. Stay away from those that have underperformed for more than 7 months.

I = Institutional sponsorship
Identify the top performing institutional investors and analyse what stocks they are buying as candidates for your own portfolio. Favour companies which are under owned but are on the buying list of institutions.

M = Market direction
Check the market daily for early signs of any major downturn. Consider trying to avoid making new purchases once a decline of 10% or more gets underway.

Closed end funds

Last week we discussed some investment products that investors could access. A product that is more readily available globally, but not necessarily locally, except in a slightly different form, is that of closed end funds.

What is a closed end fund?

Closed end funds are very similar to mutual funds – typically run by a professional investment firm, but where the shares trade on a stock market.

This means that a closed end fund has a permanent capital base that does not increase or decrease as new investors put money in or existing investors liquidate,

How does this differ from a unit trust?

This differs from a typical unit trust (mutual fund), where shares or units are created with daily demand and liquidated with investor redemptions subject to certain restrictions.

What is the major caveat with closed end funds?

One of the biggest factors that an investor needs to look for is the liquidity of the shares in the secondary market. Unlike a mutual fund where the management company is obligated to redeem units on liquidation, shares in a closed end fund can only trade in the secondary market. Invariably there is no obligation on the promoters of the fund to make a market in the shares.

Trading at a discount

The closed end nature leads to the share price trading at either a small premium or a discount to the underlying net asset value. Investors will want to look to invest when the discount materially widens up.

Two examples of listed traded funds in South Africa would include:

A new closed end fund – accessed by way of listed preference shares – will be listed tomorrow – RECM and Calibre Limited. It has placed 45m preference shares in a private placement. It has a wide mandate to invest across listed and unlisted equities.

Ultimately the investment case comes down to the management team running the investment trust or company and the various investments that they both make and exit over time that will drive up value. As with any investment, investors need to do the relevant due diligence before investing.

Losses in resource shares lead JSE down

Just before 1pm on Monday, the JSE All Share had fallen 0.5% with losses in resource shares leading the downward slide.

The rand was trading at R7.79 at 1pm, weakening slightly in line with a falling euro.

Oil cost $72.03, down 0.7% after last week’s disappointing economic data from the US indicated that recovery may be slowing, which has negative implications for future oil demand.

International markets

The Dow Jones dived 3.15% while the Nasdaq lost 3.64% on Friday, after May's poor employment statistics sent investors scurrying for cover, worsening the retreat after signs of a developing debt crisis in Hungary.

Japan’s Nikkei average fell dropped 3.84% this morning after Hungary’s debt problems saw the euro slide to an eight-year low against the yen.

China’s Shanghai index fell 1.64% on negative sentiment, with banks leading losses after the Agricultural Bank of China's impending initial public offering caused concern that its fundraising activity would reduce market liquidity.

Britain's FTSE 100 had dipped 0.45% just after 1pm after weakness in banks and mining shares followed US economic data and Hungary debt worries.

Share price news

Top mover upwards just after 1pm was Fairvest Property Holdings Limited (FVT) whose shares rose 15.04% to R1.30, after investors traded 7 000 shares in a single deal.

Mix Telematics Limited in the business support services sector gained 5.77% as 93 000 shares were exchanged in 5 deals, lifting the share price to R1.10.

The largest percentage loss was experienced by Mazor Group Limited in the building and construction materials sector. Share prices fell 10.31% to R2 each after 4 deals traded 38 369 shares.

A Brief Look at Investment Products

Saving for retirement can be a daunting task. Nevertheless it needs to tackled head on to ensure that you can retire with the same, or a similar, living standard that you had when you were still working.

There are a wide range of assets that one is able to invest into which are generally the primary drivers of the return you receive. Today, however, we’ll take a look at some of the investment products that are out there. While the product won’t drive returns, they can enhance or detract from returns. Ensuring that you invest in credible product is essential to reduce the probability of fraud occurring in your investment vehicle.

We will take a brief look at unit trusts, hedge fund investments, and private equity (via an endowment).

A unit trust is a relatively easy simple investment to understand. All investors’ money is pooled together, and managed by the manager. Each investor is issued with units from the pool, and these units are priced daily with investors being able to draw funds daily (although it might take a couple days to land in your bank account). Costs are relatively low, and there is a lot of flexibility in a unit trust structure. The large portion of investors’ money is typically invested into unit trusts for these reasons. Stock market gains are taxed at CGT rates only on realisation.

Hedge funds come in a host of forms; some are relatively straight forward, while others have complex mandates. A simple long/short fund will look to go long (buy) shares/derivatives where the manager perceives value, and short (sell) derivatives where the security is overvalued. Different funds will have different mandates, which will determine how much gearing the manager can use, and other important risk constraints. Hedge funds often come in the form of Limited Liability Partnerships. Hedge funds are often only priced once a month, and sometimes have a lock in period. There’s still some debate as to whether gains should be taxed at CGT or Income tax rates, there is also uncertainty as to whether these gains should be taxed as and when they occur in the fund, or only on redemption from the fund.

Private equity is typically accessed through an endowment structure, where your investment is locked up for at least 5 years (subject to certain withdrawal provisions); the manager then uses your money to invest into private equity funds. As these funds aren’t publicly traded, they are priced infrequently (typically once a quarter), and withdrawals prior to the fund maturing can be penalised. Endowments are taxed within the structure, and a favourable tax rate is used, so the value that you receive at maturity is tax free. Hedge funds can also be accessed through an endowment.

Investment complexity creates opportunities, but also increases risks. You need to be sure that the potential opportunities outweigh the potential risks that exist before investing. If you can accurately ascertain the risk levels, and you believe that the risk/return payoff is justified, then it may well be worth looking at investments that are generally marketed for sophisticated investors. Be aware, however, that ‘sophisticated investors’ don’t always get it right, just ask some of the investors into Bernie Madoff’s funds.

Having a thorough understanding of your needs will help you make the correct call when it comes to deciding on what asset class and what structure you should invest in.

JSE flat as investors await data from the US

Local markets

On Friday at 12:00, the JSE All Share had slipped 0.10%, though steadier after a volatile last session. Investors await economic data from the US due out later today, including non-farm payrolls, inflation pressures, and weekly measure of future US economic growth.

The rand was selling at R7.65 to the US dollar, remaining within a range as the local currency followed movements of the euro, ahead of the release of key economic data.

Oil cost $75.80 a barrel, up 2.85% by midday, on investor hopes that US monthly employment data will provide reassurance about the strength of economic recovery.

International markets

Yesterday, the Dow Jones edged up 0.06% while the Nasdaq rose 0.96% after a late rally in technology shares. Investors’ reactions were mixed after remarks from three top Federal Reserve officials, who said it may soon be time to begin raising US interest rates as economic recovery continues.

Japan’s Nikkei average fell 0.13% this morning, despite yesterday’s strong gains after Finance Minister Naoto Kan was selected as the new prime minister.

Hong Kong’s Hang Seng closed 0.03% lower, despite predictions that the market would trade slightly higher on hopes of positive jobs data due later from the US.

Britain's FTSE 100 had gained 0.83% by noon, lifted by BP after the company put a containment cap on the gushing well pipe in the Gulf of Mexico, and investors anticipate a strong May jobs report from the US.

Share price news

Experiencing a surge of trade as 402 deals had exchanged 1 787 586 shares by midday, Sappi Limited (SAP) in the paper sector climbed 2.92% to sell at R30 a share.

Have retail shares run too hard?

Have retail shares run too hard, now that sales figures are only just starting to pick up? Some investment managers think not, while other deeper value managers believe that its time to sell those Woolies shares and generally reduce exposure to this sector.

The JSE All Share index is segmented into the following industry sectors:

Just over 1/3 of the consumer services sector is made up of general retailers and therefore it’s a relatively small component of an index tracking portfolio. Induced here are companies such as Truworths, Foschini, Mr Price, Woolworths JD Group etc.

Looking at the performance of the some of these shares relative to the JSE over the last 2 years we see strong outperformance. The chart below gives clear evidence of the strong outperformance.

This outperformance was achieved on the back of retail sales that having peaked in 2008, declined and has only recently started improving again.

The May release of March retail sales reflected a 1% year on year increase, having recorded successive declines since February 2009. Food and beverage sector gained 9,7% year on year, clothing and footwear 9% and furniture and appliances 9,4%.

Source: Nedbank

This is another clear example of price leading economic and actual fundamental news. At some point the consumer sector prices in all the good impending news and becomes fully priced.

The road to recovery

Global markets don’t appear to have much direction after declining sharply in May, but investors need to look at the bigger picture. Year to date the Dow Jones Industrial index is down around 2,8% and the S&P500 down 2,3%. Its interesting to see the S&P500 with an equal weighting of shares (as opposed to market weighted) is up 2,25% for the year to date.

The world index declined 9,7% in May, bringing the loss to 6,6% for the year to date.

After a strong recovery off a market low 15 months ago, there is a possibility that market prices track sideways for a period of time.

The chart below compares the S&P500 from 2 previous troughs – the first in 1974 and the second in 2002.

After the first 12 months, the current recovery is ahead of both the 2 previous recoveries, even after the recent decline. What followed was a steady but shallower incline.

The chart of the S&P500 index in the 1960’s and 1970’s reflects the broad up and down movement of prices.

It was only until the early 1980’s that prices entered into a 2 decade general uptrend, punctuated by some sharp declines, such as in 1987.

This type of sideways market is a stock pickers market. i.e. not buy and hold.

In a world where “cash is trash” the alternative investments are not that attractive and so investors have little choice but to expose a portion of their capital to riskier assets.

In a possible sideways market, investors should continue to maintain a diversified investment strategy.

JSE follows global markets lower, as euro zone worries linger

Local markets

At 11:00, the JSE All Share had fallen 0.81%, as resource stocks weakened and the local bourse followed lower closes on international markets amid continued worry over the financial health of the euro zone.

The rand was trading at R7.70 to the dollar, remaining steady and within a range, tracking movements of the euro.

Gold cost $1 220 an ounce at 11:00, 0.57% down as investors consolidated their gains after yesterday’s rally.

International markets

The Dow Jones closed 1.11% lower while the Nasdaq lost 1.54% yesterday, as energy shares fell after US government announced a criminal investigation of the ongoing BP oil disaster in the Gulf of Mexico.

Thematic Investing

Thematic investing has become very popular over the years. Intuitively investing across current themes makes a lot of sense, but the reality is that it is far from easy. This develops from the fact that once a certain theme starts to appear attractive, it may well just be the time to be moving in the opposite direction.

Naturally first entrants spotting the direction that the market will take can benefit hugely, and hence the approach has plenty of adherents.

It is the notion of trying to identify some of the current fads or themes that may be found on the radar screen.

A popular investment process is to identify themes that may be attractive over the ensuing 12 months or more and then attempt to marry with a so called “bottom up” process which is a company by company or security by security fundamental analysis.

The 3 of the 5 main investment themes that global macro strategy hedge fund, Woodbine (ex Soros management) noted at the beginning of the year included:

• Exit strategies from monetary policy. Here they were buying fixed income and currency of countries that were starting to increase interest rates, e.g. Australia
• Capital goods divergence. Investing long in capital goods tied to emerging world and short companies providing capital goods in countries with excess supply.
• Emerging market demand. Bullish Asian currencies and also some of the financial lenders in Asia.

A strategy adopted by global fund managers Sarasin and Partners in 2010 is:

After listening to a range of fund managers last week and this week, there appears to be a high consensus that economic growth is going to continue to be derived from emerging markets and especially the emerging market consumer.

Where there is some divergence of opinion is how to access this growth. Some fund managers continue to find value in emerging markets, while others prefer the “lower risk” option of accessing emerging market exposure, but via large multinationals domiciled in developed markets.

While not all investment managers will follow a thematic approach, what is more important to longer term success is that whatever investment process is followed, is done so systematically.

Signs of slowing growth in China weighs on markets

At midday on Tuesday, the JSE All Share had fallen 1.42%, with losses led by oil and gas and financial shares. Sentiment was negative in line with weaker global markets.

The rand was trading at R7.76 to the US dollar at noon, weakening as investors’ increasing risk aversion dented emerging markets.

Oil cost $71.88 a barrel, retreating 1.53% after earlier gains as Chinese and European data raised concern over the pace of recovery of the world economy.

International markets

The US markets were closed yesterday for a public holiday.

In Japan, the Nikkei index closed 0.58% lower this morning, after an erroneous transaction weighed on the market and trade volumes were thin.

China’s Shanghai index dropped 0.92% after news that manufacturing activity grew at a slower pace in May than in April.

Britain's FTSE 100 fell 2.15% by noon, after BP shares slumped as efforts to stem the major oil spill have failed, and Prudential shares’ gains after AIG refused its revised offer for AIA were not
sufficient to lift the index into the black.